Pilgrimage, Part VIII: Who Do You Trust?

But that sounds a bit too snooty for this gathering of Berkshire-Hathaway owning, Warren Buffett-idolizing folk.

After all, they come from what might be called, metaphorically speaking, the solid middle of the country, even if technically speaking a large portion hail from the two coasts, not to mention many foreign countries.

They are also, almost entirely—and I mean it literally—white.

Now, that is not a premeditated observation on my part. It never crossed my mind that the racial mix of Berkshire-Hathaway shareholders would find its way into my notes—nor did I expect to find myself counting heads.

However, to not notice the few African-Americans at the Qwest Center while sitting in the arena, or standing on line for lunch, or walking around the exhibition hall, would be like going to a Yankees-Red Sox game at Yankee Stadium and not noticing the Red Sox fans: they just stand out.

And when I say the “few” African-Americans, I mean precisely eight in total: six men and two women.

You can blame what follows on the influence of listening to Warren Buffett for half a day, because Buffett has a way of putting numbers into strikingly clear perspective that's contageous, and probably poorly imitated on my part. For example, at the start of the meeting he reported on a shareholder resolution calling for Berkshire to divest its PetroChina position this way: only 1.8% of all shareholders had voted for the resolution, he said, adding,

“Even if you leave out my personal vote, it was a 25-to-1 vote in opposition.”

Consequently, I find myself examining the racial mix of the shareholder meeting in this way: having seen eight African-Americans out of the many shareholders I could see clearly enough to notice a skin color; and assuming by day’s end I will have seen one quarter of all 27,000 shareholders in attendance; I extrapolate a total of 32 African-Americans are at the Qwest Center.

Arbitrarily tripling that strikingly low number to 96 and dividing 96 by 27,000 yields an African-American shareholder constituency of 0.35% of those present—less than half of one percent.

Since African-Americans comprise approximately 13% of the United States population, their “share” of Berkshire-Hathaway stockholders is not even a tenth of their overall “share” of the US population as a whole.

But, you might ask, so what?

This is, after all, America, and nobody’s stopping anybody from buying a stock—let alone from attending an annual meeting.

Besides, you might well ask, is the Berkshire-Hathaway shareholder racial mix any different from a gathering of you snooty Wall Street hedge fund types?

In fact, the answer is no. It is not much different at all.

The disparity I’ve noticed out here in the, metaphorically-speaking, at least, middle of America, is something I’ve witnessed up close and personal for 28 years on the business end of Wall Street.

In those 28 years I have known exactly two African-American investment professionals (that does not include several others I’ve known of or admired from afar, such as John Rogers of Ariel Capital).

And of those two, one was immensely successful, the other immensely not.

The successful one was a technology analyst who worked harder than anybody else in the business and knew more about his companies—and not just about the numbers, but also about the software they sold—than any analyst on Wall Street, whatever their skin color.

His counterpart was likewise an analyst, and not only an African-American, but also a woman. And this was back in the days when there were only a handful of female analysts on Wall Street, and they were considered pioneers.

Being a woman on Wall Street is no longer a novelty, of course—close to half the analysts I know and depend on for ideas are female, although not many run hedge funds. African-American analysts—and hedge fund managers—are, still, even more scarce than female hedge-fund managers.

That successful technology analyst I mentioned went on to help run a giant software company.

What happened to his counterpart, I have no idea, but I think of her—nervously smoking (you could smoke inside office buildings in those days) as she tried to finish reports that never seemed to get done, burdened by pressures I could not even begin to imagine—as we resume our seats for the afternoon session, and I wonder whether Buffett sees an inequity when he looks out into the arena.

Probably he does not, given the lights shining on the stage, which cause him to shield his eyes whenever he looks for an individual out in the crowd—as when a question about Florida’s new insurance laws causes him to search for Joe Brandon, the CEO of General Reinsurance, to handle the question.

Still, Buffett does project a compassionate sensibility throughout the day.

In response to a question about recently announced plans to give away his fortune, Buffett dismisses the notion that his commitment to donate $37 billion worth of Berkshire-Hathaway stock to various charities is some kind of sacrifice on his part.

After all, he says, he still does exactly what he loves doing every day.

A sacrifice, he goes on, is “if someone gives up…a trip to Disneyland because they donated [to a charity]…”. He says flatly, “I haven’t given up anything.”

At another point, discussing the meltdown of the sub-prime debt market, Buffett calls the teaser rates and other no-interest loans practices that triggered the current bust “dumb lending and dumb borrowing.”

But he seems most offended by the high, hidden fees the mortgage brokers pulled out of the deals thanks to the easy available credit and the naïveté of the borrowers. The fallout, of course, will hurt those who can least afford it:

“You’ll see plenty of misery,” he says.

Charlie Munger, on the other hand, projects a colder, more aloof sensibility on stage, rarely unfolding his arms even while he makes a point by leaning slightly towards the microphone on the desk before him.

Adding his two cents to Buffett’s comments on the sub-prime debacle, Munger says that it is in the nation’s interest “to give loans to the deserving poor,”

“However, the moment you give loans to the undeserving poor or the stretched rich, it’s trouble.”

It isn’t clear to me who the “undeserving poor” might be, aside from the people who got screwed—there’s no other word for it—by their mortgage brokers.

Still, the meeting moves on, and it is later in the afternoon session Munger lets loose a quip that results in the single most uncomfortable moment of the day—and shocks a good portion of the crowd.

It occurs in response to a rather bland question regarding Buffett and Munger’s views on the usefulness of “hurdle rates.’

“Hurdle rates” are standard MBA fare—the minimum rate of return a company or an investor like Buffett requires before spending capital or buying a business. Whether it is a fixed number, such as 10%, or keyed off a company’s cost of capital, it represents a figurative “hurdle” the contemplated investment or acquisition must get over.

Hence, “hurdle rate.”

Buffett, as you might expect, does not pay much attention to such textbook notions. He re-states comments made earlier in the day that equity investments in general ought to beat the return offered by treasury bonds. But the precise calculation is one he makes very informally:

“I’ve never done a spreadsheet, except in my mind.”

Munger chimes in by saying while the notion that a potential investment ought to hit a minimum standard return “makes nothing but sense,” people make “terrible” mistakes by depending on them, since they provide an artificial notion of what is acceptable.

He advises investors to consider a wide range of investment options and “think about the returns from each” before committing money, rather than making what could be a poor or mediocre investment simply because it theoretically exceeds a given hurdle rate.

Now, while Buffett tends to be energetic and wide-ranging in his answers, Munger seems to always be formulating an amusingly sardonic, pithy summation of his view on a given topic—which he will then deliver to the obvious delight of the crowd.

Sometimes he surprises us, and gets a good laugh, with nothing more than a simple, dry, emphatic “No,” when the longer-winded Buffett asks, “Charlie, you want to add something?”

Usually, however, it is an amusing metaphor or a crisply harsh judgment, such as his simple conclusion to their discussion of why Berkshire-Hathaway does not invest in the gaming industry:

“It is a dirty business.”

So even after his unusually long dissection of “hurdle rates” as a poor substitute for using common sense, we are expecting a zinger of sorts as Munger winds up his thoughts.

This he delivers, but not quite as we expect.

Speaking of the hidden surprises that may await an investor who depends solely on “hurdle rates,” Munger says, and I quote more or less verbatim:

“It’s like the fellow who orders a mail-order bride, and it turns out she has AIDS.”

Some people laugh reflexively—this is, after all, Charlie Munger speaking, “The Joker” in the Berkshire-Hathaway deck of cards. We have become used to chuckling each time he drops a line.

But the laughs freeze and there are gasps as the crowd collectively wonders, “Did he really say that?” Then the arena goes uncomfortably silent while Charlie sits back in his chair, arms crossed, no expression on his face, and Buffett hastily calls for the next question.

The point Munger was emphasizing is now lost in the vast, darkened auditorium.

That momentarily dark mood does not, however, erase the lingering impact of what has been, for me, the most interesting answer of the day to the most interesting question of the day, from one of the many budding Buffetts in the crowd.

The young man started out by telling Buffett that, while he can research a company’s financial statements and read the analyst reports, he can't really tell much about management from the numbers or the reports.

How, he asks, does Buffett know which people he can trust? How does an investor learn who to trust?

It’s a great question, and Buffett seems stumped trying to explain it.

He talks about small investors getting taken advantage of by unscrupulous advisors, about the “good luck” he and Munger have had avoiding such scams, and how they have been about "90%" successful in finding good people.

However, while their experience has been “overwhelmingly good,” Buffett says, he and Charlie “filter out a lot of people.”

Then he describes the filtering process, and it has nothing to do with numbers. It has to do with meeting people face to face:

“People give themselves away,” Buffett says. “When they come [to meet us]—the very things they talk about…. There are a lot of clues in the things they think are important.”

What he’s talking about is “body language.”

Cops are taught to read it; reporters watch for clues in it—and Warren Buffett uses it to help him make investment decisions.

I attended a citizen’s police academy years ago, and one of the sessions was given over to interrogation techniques. I remember the Sergeant summing up how he judges when a suspect may or may not be telling the truth:

“If he looks up, that’s recall; if he looks left or right, he’s making it up.”

It's the old shifty-eyed thing, and it doesn't just apply to petty thieves; it applies to management teams, too. I’ve never understood those Barron’s interviews with money managers who go strictly by numbers. Some of them actually take pride in not meeting with management. They say it helps them avoid mistakes.

Still, Enron's numbers, which turned out to be a fiction, caused a lot of investors to make a big mistake.

That's why I can't buy something if I've never met the CEO and the CFO, and I find it especially striking that the greatest investor who ever lived is talking less about numbers and more about body language.

Munger takes it even further, noting how they quickly rule out deals that merely seem, on the surface, too easy:

“We’re deeply suspicious if it sounds too good to be true.”

He describes one such deal—an insurance company that supposedly only wrote fire insurance on underwater concrete bridges, and draws a laugh.

Buffett picks up on this—it’s not just the numbers or the body language behind the numbers that matters, he says, but how the numbers themselves are presented and the language that is used:

“They [promotors] make certain kinds of comments… What they laugh about... They say ‘it’s easy’… It’s never easy. We get suspicious very quickly [if the numbers sound too optimistic]. We rule them out 90% of the time.”

I recall the Berkshire-Hathaway manager telling us during the lunch break that Buffett wanted to see him in person—not to make a detailed presentation on the proposal, but:

“He just wanted to see us tell him in person we thought it was a good deal.”

Buffett had the numbers. But he wanted to see it in their faces.

The information load is taking a toll. As the questions get less interesting, I take a quick, head-nodding-to-the-chest kind of nap, and snap out of it, refreshed, while Buffett is answering a question about the New York Times and whether the dual-class shareholding structure of that company has something to do with its problems.

Buffett discourses on the poor economics of newspapers in an Internet age, as he has done in other forums, by asking rhetorically if anybody would choose to invent the newspaper as a form of news distribution today—costly, untimely and inflexible as it is.

The obvious answer is no.

Still, for all his hard-nosed observations about newspapers being a dying business, Buffett’s only real clunker of a piece of advice will come in response to that 10-year old girl from Kentucky mentioned previously...and it will involve newspapers.

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

In my business (i-banking), I consider the initial meeting with a management team to be absolutely essential, but only as a way to kill (i.e., not take on) a potential deal-- NEVER as a way to "affirm" one. What I'm trying to say is this: I've NEVER had a "bad feeling" about a company's management turn out to be wrong, but I've been fooled LOTS of times by managements that seemed great but then turned out to be "bad guys." Thus, when I now meet a management team, I no longer allow my "gut feeling" to move me TOWARDS taking on a deal, but only towards NOT taking it on. So, the only conclusions I'll allow myself to draw from such a meeting are "negative" or "neutral", and if it's "neutral," well, after that, it depends on "the facts."

Having been responsible for the investment activity of Individual Investors for the past 35 years, I wish I could convince all of the investing public to read your thoughts.

This is priceless information for everyone.

Buffett not only gives us a lesson in investing but also in clear headed and original thinking.Most of the individuals who have given me the opportunity to help them invest their savings have never learned that skill.

Unfortunately, it seems to me that the "Sell Side", at least at the retail level, has not learned the lessons Buffett has to offer.Hardly a day goes by when I don't hear of a new scheme to increase the "ROA", none of the schemes mention how it will help the client.